Retirement Focus: Target-Date Funds in the Crosshairs

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
August 11, 2009

Retirement Focus: Target-Date Funds in the Crosshairs
By Mike Posey

IN THIS ISSUE:

1. Target-Date Funds 101

2. Advantages of Target-Date Funds

3. Criticisms of Target-Date Funds

4. The Feds Come Down on Target-Date Funds

5. Buy-and-Hold on a Stick

Introduction

Target-date mutual funds are a fairly recent entry into the mutual fund field, having been first introduced in the early 1990s. Since then, they have become very popular – especially after the passage of the Pension Protection Act in 2006. For those of you who may not be familiar with this type of investment, target-date funds are specialized mutual funds that offer an investor the option of buying a single fund that invests its assets based on an assumed date of retirement. As retirement nears, the fund’s allocation is usually changed to become more conservative.

These funds have become hugely popular with investors because they represent a one-stop shopping opportunity for a diversified portfolio. Thus, they appeal to individual investors and 401(k) participants who are not comfortable making their own portfolio decisions. Just pick your date of retirement and your investment decision is made.

Usually structured as a mutual fund that invests in other mutual funds (a “fund-of-funds”), target-date products automatically allocate an investor’s assets among a variety of asset classes, generally based on traditional asset allocation techniques.

Due to the simplicity of this approach, target-date funds have become standard features in scores of 401(k) plans where participants must direct the investment of their accounts. The premise is easy – just put your money in the fund that corresponds with your normal retirement date, sit back and let the fund take care of the details. At least that’s the theory.

Too bad things have not gone as well in actual practice. Federal regulators including the Department of Labor and the SEC have been looking into the performance of these funds during the recent bear market. In addition, regulators are investigating the “need for additional guidance given the importance of these investments to the retirement savings of investors.”

In this week’s Retirement Focus E-Letter, I’m going to discuss the development of target-date funds, how they work and their advantages to investors. I’ll also discuss the shortcomings of target-date funds, which became painfully evident over the course of this bear market. What we’ll find is that, like many one-size-fits-all approaches, target-date funds can have some serious drawbacks.

The Basics of Target Date Funds

As I noted above, target-date funds are a one-size-fits-all investment solution usually structured as a mutual fund that invests its assets exclusively in other mutual funds. In most cases, the mutual fund family that sponsors the target-date funds directs its assets into other funds within the same fund family. Since most fund families sponsor a wide variety of mutual funds, it’s usually not hard to achieve the fund’s directive for diversification through an asset allocation strategy.

Target-date funds are also sometimes called “lifecycle funds,” because they seek to provide an automatic approach to investing over time. As such, they are typically sold to investors as a sole investment. Otherwise, holdings outside of these funds could throw the asset allocation out of whack. For example, if a younger client put half of his or her 401(k) account in a target-date fund that had 80% invested in equities, yet held the other 50% of the account in cash, this would greatly reduce the overall equity exposure. Thus, target-date fund proponents suggest that participants should invest all of their contributions in this type of fund to get the best results.

Over time, target-date funds slowly shift their assets to more conservative funds as the assumed retirement date nears. In the industry, this is known as the fund’s “glide path.” As a general rule, the longer the fund has until the target retirement date, the higher the percentage invested in stocks. As the retirement date nears, more of the portfolio is shifted to bonds and other fixed-rate investments.

While allocations within target-date funds are generally based on asset allocation and Modern Portfolio Theory, it would be a mistake to assume that all funds have similar stock/bond allocation ratios. There is a wide variation in the amount of assets invested in equities and bonds, even among target-date funds with the same assumed retirement date (more about this later on).

Since all funds are not created equal in regard to the allocation to stocks and bonds and the glide path used, it is up to participants to determine whether the specific allocation method of any given target-date fund is appropriate for their investment goals and risk tolerance.

Advantages of Target-Date Funds

While many investors are not interested in a fund that makes all of the investment decisions for them, the creation of target-date funds did serve a real need. In the past, I have written about how some 401(k) participants will not make a decision as to how to invest their contributions. As a result, these contributions sit in low-earning cash or guaranteed-return funds, offering little hope of meeting the participants’ retirement goals.

Target-date funds attempted to fix that by allowing a participant to make a single decision based on their assumed year of retirement. In theory, nothing could be easier. The participant was invested in a fund with the potential for growth and the employer was able to escape possible fiduciary liability for allowing an employee to remain in low-yielding investments.

However, even with this simplification, there were still 401(k) participants that would not even elect to invest in a target-date fund based on their retirement date. To remedy this situation, the Pension Protection Act of 2006 allowed employers to select “default” investments for participants who would not or could not make their own elections.

This law also strengthened automatic enrollment policies, so that now an employee can be enrolled into a 401(k) and have his or her money invested in a target-date fund without taking any action or making any investment decisions. Obviously, this is not a wise course of action on the part of the employee, but it can serve as a fail-safe for those who simply won’t take action to secure a retirement nest egg.

Other advantages of target-date funds include the following:

Ideally, a target-date fund not only allows a participant to make a single investment decision upon participation, but also handles future rebalancing and allocation adjustments necessary to reduce portfolio risk as participants get older. In other words, it’s billed as being a “set it and forget it” investment;
Likewise, in an ideal world, the target-date fund would not only provide for growth prior to retirement, but also provide a way to help retirees not outlive their money. The rationale here is that, absent target-date plans, many retirees move all of their money to “safe,” fixed-rate investments upon retirement to avoid losses. By doing so, however, they might subject themselves to returns so low that they end up outliving their money. Many target-date funds maintain some level of equity investment even into retirement, which provides the potential for additional growth. Of course, it also provides for the potential for losses;
Gary has written many times about how studies conducted by the Dalbar organization show that investors who frequently change funds forfeit much of the long-term return. Target-date funds can help curb the desire to chase the latest hot performance among optional 401(k) investments by removing the need to make subsequent investment decisions after the initial purchase;
Many target-date funds have low minimum investments, making them available for even relatively small 401(k) contributions;
Asset allocations are managed by professionals within the mutual fund family sponsoring the target-date fund. Thus, participants have the potential benefit of professional management, but they are usually limited to an asset allocation strategy, which is a form of buy-and-hold investing that I do not recommend;
Some target-date funds offer the use of traditional mutual funds while others select among only passive index funds. The presence of a fund manager who tries to add value over and above the performance of an index can be an advantage, but there are no guarantees that they can always do so; and
Target-date funds can be an excellent way to take advantage of a strategy known as “dollar-cost averaging.” This strategy is based on making investment purchases at regular intervals (usually monthly). Over time, contributions buy more shares when prices are lower and fewer shares when prices are high. The ultimate goal is to lower the total average cost per share purchased over a participant’s working lifetime.

Disadvantages and Criticisms of Target-Date Funds

Almost since they were first introduced, target-date funds have met with criticism. Primarily, critics focus on the idea that a one-size-fits-all solution is rarely, if ever, appropriate for everyone who owns the fund. We know this to be true as the risk tolerance, return expectations and a host of other variables often determine an investor’s comfort with a particular portfolio allocation.

Some dismiss this criticism by noting that 401(k) participants generally have the choice of whether or not to select their own mix of funds from those offered in the plan, so if a target-date fund is selected they should be satisfied with the result. This may be true, but it doesn’t help participants who might get out of target-date funds because they are too aggressive for their risk tolerance.

Target-date funds have been the subject of a number of other criticisms, including the following:

Many target-date funds are sponsored by mutual fund families that allocate its assets only among mutual funds sponsored by the same organization. While this is not a guarantee of poor performance, a single mutual fund family usually does not have superior funds representing all asset classes;
Target-date funds are also sometimes criticized for adding a layer of fees on top of those charged by the underlying mutual funds in which they invest. In fact, some fund companies “double dip” by charging fees on the underlying funds as well as on the target-date fund. Others, however, do not charge additional management fees for their professional management services. Thus, it’s important to check on what fees will be charged before making a decision to invest;
One of the biggest disadvantages of target-date funds is that it’s sometimes hard to tell exactly how it will be managed over time. As I noted above, asset allocation strategies can vary widely among fund families, and can even be modified within a fund as time goes by. For instance, I read several articles back in the summer of 2008 that discussed how target-date funds were increasing their allocations to stocks. Guess how those funds did over the last half of 2008!

The lack of easily understood labeling on target-date funds can actually help to defeat the simplicity they try to provide. Participants who do not want to make their own asset allocation decisions are not likely to want to dig through a prospectus to see how their target-date fund will be managed. Plus, according to a 2008 study by the Financial Research Corp., it was even hard for professionals to discern specific investment strategies, making it very difficult to compare one target-date fund to another.
On a related note, recent research has found that the amount of a target-date fund’s allocation to equities can vary widely among fund sponsors, even when the funds are close to their target retirement date. While many experts agree that some exposure to equities is necessary in retirement to provide a potential for growth, most agree that this allocation should be rather small.

A good example comes from a 2008 Investment News article that noted the Oppenheimer Transition 2010 Fund (designed for someone retiring in the year 2010) had 75% of its assets invested in stocks. Not surprisingly, it lost over 41% of its value in 2008, a loss even greater than that of the S&P 500 Index’s drop of 37%. Now, just think of retirees in this fund that have just two years or less before retirement. It’s unlikely that they’ll make back much, if any, of this loss prior to their target retirement date;
Another possible disadvantage brought about by all the variation in target-date funds is that employers who use these funds as default options may find themselves having liability for selecting the wrong default fund;
While most fund companies and employers have done a good job communicating about how target-date funds work, a recent study by Janus Funds found that 60% of target-date fund holders incorrectly believe that these funds provide some pension-like guarantees. They do not offer any guarantees and are subject to market losses, as most participants found out in 2008;
As both employers and plan participants seek to evaluate and compare various target-date funds that may be available to them, they often find that the target-date funds have a very limited actual track record. The number of target-date funds has exploded in the last few years, so many have little to show as far as a track record. You can try to get a better picture by analyzing the track records of the underlying funds used, but this can be a rather complex task.

Even worse, a participant must not only decide if the current allocation is appropriate for his or her investment profile, but must also see if the glide path will result in an appropriate allocation in all future years. In other words, a target-date fund investor must decide up-front if all future allocation adjustments will be appropriate for his or her financial situation at that time, something that is impossible to know.

Again, I doubt that participants who already don’t feel comfortable making their own investment decisions will go to this trouble. If not, they’ll either stay invested in low-yielding investments, or pick the first target-date fund that sounds good without determining whether it is the most suitable option for them. Either way, their retirement security may be at risk;
As I noted above, target-date funds are designed to be a sole investment rather than part of an allocation of various funds. As such, however, a target-date fund may conflict with other investments a participant may hold outside of the 401(k) plan; and
While target-date funds may be useful for young participants who can benefit from dollar-cost-averaging, it may not be the most suitable investment for large accumulated balances. I’ll discuss this in more detail later on, but target-date funds are nothing but buy-and-hold strategies on autopilot, which could subject large nest eggs to potentially significant losses.

As I have previously noted, any one-size-fits-all solution is bound to have negative implications for some who invest in these programs. However, target-date funds seem to have more than their fair share of disadvantages that can moderate, or even eliminate the advantages of these funds, depending upon the participant’s personal situation.

The Feds to the Rescue

To say that many target-date funds did not fare well in the bear market of 2008 would be a vast understatement. In fact, we can say that most target-date funds didn’t do very well. According to a recent speech by SEC Chairman Mary Schapiro, funds with target retirement dates of 2010 had returns in 2008 that varied from minus 3.6% to minus 41%. This is a huge disparity for a group of funds that are supposed to be designed for 401(k) participants retiring next year.

As you might suspect, the primary culprit causing this spread in returns was the wide variation in the stock allocations within the various target-date funds. Those with larger allocations to equities had the greatest losses, while those with lower equity allocations had smaller losses. However, large losses for employees who are close to retirement age were seen as especially disturbing to the SEC and Department of Labor (DOL), not to mention the unfortunate 401(k) participants who invested in these funds.

Plus, some funds actually increased their allocation to stocks last year, just before the market meltdown, in what can only be described as an attempt to chase returns. Supposedly, investors are paying their professional managers to apply a disciplined approach to investing, but chasing returns is what the Dalbar organization has identified as the reason average investors often earn poor returns. In my opinion, this is simply inexcusable for a professional money manager.

As a result of the shortcomings of target-date funds, the SEC and DOL held a joint hearing on these investments on June 18th. The purpose of this hearing was to have an “in-depth discussion” about the role of target-date funds in retirement planning as well as the need to improve regulation of these funds and better protect retail investors. In her opening statement, SEC Chairman Schapiro said:

Target date funds have become an increasingly popular investment option for Americans investing for retirement and educational needs. These funds and other similar investment options are financial products that allocate their investments among various asset classes. These funds automatically shift that allocation to more conservative investments as a “target” date approaches…

The “set it and forget it” approach of target date funds can be very appealing to investors. Target date funds were expected to make investing easier for the typical American and avoid the need for investors to constantly monitor market movements and realign personal investment allocations.

But, the reality of target date funds was quite surprising to many investors last year. It has been reported that the average loss in 2008 among 31 funds with a 2010 target date was almost 25 percent…

These varying results should cause all of us to pause and consider whether regulatory changes, industry reforms or other revisions are needed with respect to target date funds. And this is what I hope today’s joint hearing will help us assess.

I researched our Morningstar Principia Pro software to find the 2010 target-date funds and did a bit of additional analysis. As usual, I searched only the “distinct portfolios” so that I wouldn’t get multiple share classes of the same fund. The result was a group of 50 mutual funds falling within the “Target Date 2000 – 2010” Morningstar Category.

Sure enough, these funds had a wide variety of equity exposure, ranging from a low of around 10% to a high of over 65%. It is also important to note that this equity exposure was not just in relation to domestic stocks, but some funds had over 20% allocated to non-US stocks, which are usually deemed to be more aggressive than domestic stocks due to the currency risk involved.

In light of these statistics, it does appear that something probably needs to be done to standardize target-date funds, or at least provide for more disclosure. As I have said above, my concern is that investors may blindly buy a fund with the right target retirement date not knowing that the underlying investments may be far too risky. Of course, this can be avoided by carefully researching the prospectus, but the more research and due diligence is required of the participants, the less these funds are likely to be used. After all, the idea is to provide a solution to those who either can’t or won’t make their own asset allocation decision.

Plus, the skeptic in me wonders how effective the DOL and SEC will be in regulating these funds. After all, the DOL is the agency that approved these funds as a default investment just a couple of years ago, when all of the shortcomings of these funds were already well known.

Industry Not Waiting For Regulation

As you might imagine, the mutual fund industry is vowing to fight government regulations that dictate allocation percentages within target-date funds. The fund industry is also developing the next generation of target-date funds in an effort to correct the problems found in current products. One new innovation is to remove the requirement that all asset classes are managed by the same fund family. This “open architecture” could diversify the management of these funds, but might do little to affect the wide variation found in equity allocations.

Yet, I have to wonder whether the fund industry really understands the situation they have put target-date fund investors in, especially those who are close to retirement. A benefit plans consultant is quoted as saying the following in response to the industry’s attempts to fix the inherent problems found in target-date funds: “It usually takes two or three tries to get the products right. The next generation products will correct deficiencies that the current crisis revealed.”

And what about the retirees and near-retirees whose account balances are at risk while the fund industry makes these attempts to get its act together? If it’s going to take two or three tries for the industry to get it right, you have to wonder what additional problems lie in these funds just waiting to spring upon unsuspecting investors.

Perhaps the most important news is coming from large corporate employers who are creating their own custom target-date portfolios using investments selected from among the various options available in their plans. These large employers can even customize their portfolios based on workplace demographics and the presence of other retirement plans. Unfortunately, this does little to help the millions of participants who work at smaller employers.

Conclusion: Buy-and-Hold on a Stick

While I do agree that target-date funds serve a purpose in that they offer a simple way for a 401(k) participant to invest when they might otherwise leave their contributions in cash, the variations in allocation methods and lack of transparency make it questionable as to whether these funds are better than the alternative. After all, the guys who left all of their contributions in cash or “safe” investments are looking like geniuses right now.

I am also concerned that many employers may have adopted target-date funds without appropriate analysis, and may now have subjected themselves to liability. One study suggested that 80% of large employers now offer target-date funds. These funds could be ticking time bombs if they have questionable allocations or an inappropriate glide path. Thus, employers could find themselves facing the very liability they sought to escape by using the target-date funds in the first place.

In the end, the real shortcoming of target-date funds is that they are simply buy-and-hold strategies on autopilot. As such, they have all of the shortcomings of buy-and-hold that Gary has written about many times in this E-Letter. Even if the DOL and SEC are successful in standardizing target-date fund allocations, it will be within the context of a buy-and-hold asset allocation portfolio.

As a practical matter, many employers who sponsor 401(k) plans opt for buy-and-hold mutual fund solutions at the direction of brokers or financial advisors who know of no other way to invest. It’s too bad that they ignore active management strategies that might be attractive to participants who see the value of moving to cash to manage market risks.

The only thing clear at this point in time is that target-date funds will soon be changing. Let’s hope it’s for the better. In the meantime, if you are invested in a target-date fund, I suggest that you request a prospectus on your fund and read it carefully. See how your money is allocated now, and also how this allocation will change as you proceed down the glide path.

Hoping you retire in style,

Mike Posey

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